By Jan. 18 the city of Vallejo, Calif., must submit a bankruptcy-exit plan to a Sacramento court. The plan will outline how the municipal government will meet $195 million of unfunded pension obligations, trim employee benefits, delay payments to bondholders, and set aside money for unsecured creditors.

If the court approves the plan, the city of 120,000 will be one step closer to the end of a painful experiment in restoring Vallejo's finances. When Vallejo filed for Chapter 9 bankruptcy protection in May 2008 after failing to win pay cuts from the city workers' unions, Vice-Mayor and Councilwoman Stephanie Gomes said officials around the U.S. would have their eyes trained on the city, which sits 32 miles north of San Francisco.

The lesson other cities have drawn from the two-year-old case, which has cost Vallejo $9.5 million in legal fees and made it a nationwide symbol of distressed municipal finances, is that out-of-court negotiations yield better results. "They spent a lot of money with very little outcome," says Jay M. Goldstone, San Diego's chief operating officer, who relied on negotiated pay cuts and higher benefit contributions from the unions to resolve his city's fiscal crisis in 2009.

"A lot of cities looked at Vallejo and concluded that painful as it might be, there must be a better solution than to pay millions in legal fees and give control of their city to the bankruptcy court," says Paul Rosenstiel, California's deputy treasurer from 2007 to 2009 and now a principal with municipal-bond underwriter De La Rosa in San Francisco.

Five municipal entities sought protection in 2010 compared with 10 in 2009, according to data compiled by James E. Spiotto, head of the bankruptcy practice at Chapman & Cutler, a Chicago law firm. Harrisburg, the Pennsylvania state capital, weighed a Chapter 9 filing in 2010 after it couldn't make $282 million of payments on bonds. The situation prompted Pennsylvania Governor Edward G. Rendell to advance $3.3 million to the city on Sept. 13. "We couldn't stand by and let the city default," Rendell said at the time, arguing that a default could raise borrowing costs elsewhere in the state. Hamtramck, Mich., which has lost funds over a disputed revenue-sharing agreement with Detroit, wants to file for bankruptcy, says City Manager Bill Cooper. The state Treasury Dept. says the city has to follow a complex procedure laid down by state law before its application can be considered.

Vallejo had no other options but to file, says Marc A. Levinson, a partner with the San Francisco-based law firm Orrick, Herrington & Sutcliffe who is drafting Vallejo's bankruptcy-exit plan. "We couldn't get the concessions from the unions and from the bondholders that would keep us out of bankruptcy," says Levinson, who works out of Sacramento. The city has since reached agreements with administrative and police unions that yielded $6 million in savings through June 2010, its website says. The firefighters union agreed to a new contract that was approved by the council in March.

The bankruptcy process could take another six months, further distracting local officials, says Christopher J. Mier, chief municipal bond strategist with Loop Capital Markets in Chicago. City residents have 159 fewer fire and police personnel than seven years ago, road maintenance is at 10 percent of recommended levels, and grants for arts and cultural programs have been eliminated. Gomes, the council member, sums it up: "It's best to negotiate your way out of the fiscal problem before you go into bankruptcy."

The bottom line: Though U.S. cities face serious financial difficulties, seeking a solution through bankruptcy is proving costly and prolonged.

Vekshin is a reporter for Bloomberg News.
Braun is a reporter for Bloomberg News.